Middle East Turmoil & the U.S. Recovery

Tensions in the Middle East appear to have given the market an opportunity to retreat. But is it the start of a significant correction that many have long been expecting? Or is it a knee-jerk reaction to the oil spike due to the Libyan violence?

I think it’s more of the latter; oil spikes have a history of getting in the way of economic stability and growth. And with Libya in the midst of a violent political struggle, concerns about oil supplies have come front and center for the first time in the ongoing Middle Eastern turmoil. It is a key OPEC member and accounts for about 2% of global oil supplies.

But as important as Libya is to the oil market, it can’t by itself shift the supply situation materially. After all, OPEC is sitting on roughly three times Libya’s daily oil production in excess production capacity. It is this redundant capacity within the oil cartel (most of it situated in Saudi Arabia) that gives it the clout in the global oil market. As such, OPEC can easily offset Libyan supplies by opening its spigots.

Loading up on oil producers to capitalize on the commodity’s upward trajectory may not be the best strategy at this stage. You will need to wait for better entry points, as the easier gains are most likely behind us. You also need to keep in mind that a number of major producers will be negatively affected by their exposure to disruptions in that country.

Many of the largest international operators in that country are from Europe. Italy’s Eni (E) and Spain’s Repsol (REP) have been forced to withdraw expatriate staff out of Libya.

Among U.S. operators, Occidental Petroleum (OXY) was a major winner of recent leasehold auctions, but does not have much in terms of actual production there. Marathon (MRO) and Hess (HES) also have Libyan exposures, but the potential production shortfall will be more than offset by gains on the commodity-price front.

The Fear Premium in Oil Prices

The jump in oil prices following the Libyan turmoil primarily reflects fears of the disturbance spreading to other major oil producers, particularly Saudi Arabia. I hate saying this, but the Saudi regime is far more stable and well entrenched than many of their regional peers.

They are masters of spreading their vast wealth around. A case in point is today’s announcement of more than $35 billion in new spending measures aimed squarely at potentially disaffected segments of the Saudi society. This helps them buy loyalties, and even enduring affection. More importantly, their co-option of the powerful domestic religious authorities gives them a level of authenticity and legitimacy that the regimes in Egypt and Libya lack.

Saudi Arabia does have a weak spot in its minority Shiite population, which accounts for about 10%-15% of the total population (the Saudi state professes the more fundamentalist Wahabi strain of Sunni Islam). The Saudi Shiites have historically felt marginalized, but have been emboldened by the rise to power of their co-religionists in next door Iraq following the overthrow of Saddam Hussein. More importantly, the Saudi Shiites demographically dominate the Eastern Province, which is home to the country’s major oil fields. With Shiites in the neighboring Persian Gulf state of Bahrain up in arms against their own local Sunni king, it would be reasonable to expect some disturbances in Saudi Arabia’s oil-rich Eastern Province. But their ability to disrupt oil production/supplies will be limited.

Given this background, I don’t expect the fear premium in oil prices to expand further. But with uncertainty hanging in the air over the region in the coming days, the premium is not expected dissipate either. The regional turmoil has brought forward the prospect of $100 oil; more so than would have been the case purely on the basis of economic forces. This will temper the economic recovery, but is unlikely to derail it.

Economic Growth on Solid Footing

Improved U.S. economic reports and continued strength in corporate profitability have been the factors driving the stock market rally since August.

Growth resumed in the GDP report for the last quarter of 2010 following a period of softness in the second and third quarters of 2010. Importantly, the fourth-quarter GDP report showed that growth was driven by household spending, which is much more sustainable. Temporary elements that drove much of the growth in earlier quarters, such government spending and inventory build-up, were effectively insignificant contributors.

Since then, reports show a continuation of the growth momentum in the first quarter and beyond. The ISM Indices are comfortably in expansionary territory at around 60. The Philly Fed Index is at a seven-year high. And the leading indicators are pointing up. Even the laggard labor market is showing signs of a turnaround, with the weekly jobless claims hovering around the 400,000 mark. The corporate profitability picture has been quite solid in this recovery, highlighted once again by the fourth-quarter reporting season. Earnings are up a solid 27% for the quarter, with the full-year 2010 gain an impressive 43%. Further earnings gains of 15% and 12% are expected in 2011 and 2012, respectively.

Commodity prices had started moving up in response to the improving economic outlook. Prices of food, energy, and other industrial commodities clearly bear this out. The current turmoil in the Middle East is giving oil prices a further nudge, which can become problematic for the recovery. Spiking oil prices are no doubt a drag on the economy. But the economy’s prospects of withstanding a $100 oil price have significantly improved in the last few months.

Putting It All Together

The Middle Eastern situation may take some time before completely unfolding. This evolving drama has the potential for destabilizing that economically and geo-strategically important region. But its ability to drag down the U.S. recovery is limited as long as Saudi Arabia remains unaffected. And as I discussed earlier, the Saudis appear to be in good shape.

The fundamentals of the U.S. economy are looking their best in a while. Use weakness resulting from the regional turmoil as a buying opportunity to own quality names that enjoy strong earnings momentum and economic leverage.

Zacks Investment Research is one of the most highly regarded firms in the investment industry. In 1978 Zacks originated the concept of utilizing earnings estimates revisions to make profitable investment decisions. Zacks offers multiple investment products and services to help investors achieve superior returns.